Taxes. They are, as Benjamin Franklin famously said, one of the two things that are certain in life -- the other being death. But why, oh why, do managed mutual funds as a group seem to go out of their way to have their shareholders pay the highest taxes possible? Where mutual funds are concerned, yearly tax hits are not inevitable, and you should certainly be considering that when looking at mutual funds. Since mutual funds on the whole make their investment decisions on the basis of maximizing before-tax returns, it is up to you to look over your mutual fund's activities to keep your tax burden at a minimum.

As we noted before, managed mutual funds on average turn over approximately 85% of their holdings every year. This active trading is perhaps best explained by mutual fund managers needing to feel like they're doing something every day. After all, at the high costs that they are charging in management fees, they need to be doing something other than putting their feet up on their desks and taking three-martini lunches, right?

Wrong. This behavior not only has the effect of reducing returns by about 0.7% per year through transaction costs, it also has the unfortunate result of creating taxable gains on those sales. This is not generally considered to be a problem by the mutual fund managers, who distribute these taxable gains to their shareholders and report their results for the year as if taxes did not exist.

Ha!

You, the fund shareholder, are the one who is going to wind up paying those taxes if you own a mutual fund that has a high turnover rate in a taxable account. So if you're choosing a mutual fund outside of an IRA or 401(k) plan, make sure that you pick one that is tax friendly.

Index Funds, of Course

The easiest way to do this is to pick a fund that has low turnover, and the funds with the lowest turnover are index funds. Because index funds are not turning their portfolios over every year or every year and a half, as so many managed mutual funds do, there are very minimal capital gains realized.

This is not to say that index funds will never have any capital gains distributions. Index funds do realize gains whenever a stock is replaced in a target index and must therefore by sold by the fund. An index fund will also be forced to sell securities in its portfolio if many investors decide to sell their shares. While index fund investors up to now may have been "buy and hold" investors, given the recent proliferation of inflows to index funds, there may be some new investors who are simply "chasing a hot fund." Therefore, should there be a sudden downturn in the stock market that causes many people sell their shares, an index fund, like any other fund, will have to sell some securities to meet the cash demands of selling shareholders. On the whole though, it can be assumed that index fund shareholders, being the most savvy of mutual fund investors, will be the least likely to panic during a market correction.

Tax-Managed Funds

Funds can also be managed with the specific intent of keeping tax consequences down despite selling off some shares. This is accomplished by carefully selecting which shares to sell to match capital gains with capital losses. While many investors do this on their own to keep their tax exposure down, most mutual funds are more likely to choose selling their winners to "lock in gains" (and lock in distributions to their shareholders) than to consider very carefully the full tax effects of their sales.

Some tax-efficient mutual funds impose fees on shareholders who sell their shares quickly after buying them. This type of fee is distinct from a contingent deferred sales fee, because it is not accompanied by an ongoing 12b-1 fee. The fee imposed by a tax-managed fund acts to dissuade those who actively trade mutual funds from buying in the first place. This allows the fund to maintain a minimal cash reserve, and to avoid unexpected sales triggered by redemptions from mutual fund traders.

Don't Buy Mutual Funds at the End of the Year

Mutual fund distributions are typically issued toward the end of the year, in November or, most often, in December. Those who purchase a mutual fund toward the end of the year may therefore be buying themselves a quick tax bill along with their fund shares.

If you're buying a mutual fund, find out when it will make its end of the year distribution and only buy shares after that occurs.

The Cost of Ignoring Tax Consequences

According to a study by Joel Dickson and John Shoven, "Taxes and Mutual Funds: An Investor Perspective" in James M. Poterba's (ed.) Tax Policy and the Economy; as much as a quarter of a mutual fund investors' annual returns are consumed by the taxes payable on dividend and capital gains distributions. Over time, the compounding effects of an average equity return of 10% being reduced by one-quarter are truly dramatic. Over the course of thirty years, with 10% annual returns, $10,000 will compound to nearly $175,000. At 7.5% returns, it will compound to $87,500 -- almost exactly half the amount. Yikes!

One good place to research and compare the effects of taxes across different funds is Investor's Business Daily, which lists five-year after-tax return figures for funds in its mutual fund tables. In looking at these tables, you will see that the after-tax returns of funds that have high turnover rates are much less impressive than those that accomplish the same or slightly lower annual returns with low turnover rates.

Tax-Deferred Accounts

The good news for investors in accounts such as a 401(k), 403(b), or IRAs is that all taxes are deferred on the capital gains distributions paid by funds held within these accounts. If you hold mutual funds within a tax-deferred account, the tax efficiency of your funds is not strictly a concern.

Does this mean investors should be indifferent to high turnover rates for funds held within their tax-deferred accounts? No. High turnover rates will still present a drag on a fund's annual returns because of the trading costs of buying and selling often. As noted before, the drag on an average managed mutual fund with 85% turnover is approximately 0.7% per year.